Businesses Must Comply with New Definition of a Business to Align with Revenue Recognition Standard by Christopher Cichoski, CPA
Posted on April 19, 2017 by Christopher Cichoski
The Financial Accounting Standards Board (FASB) recently issued an Accounting Standards Update (ASU) that clarifies the definition of a business when used in transactions involving the acquisition, sale or consolidation of a business or assets. More specifically, ASU 2017-1 provides companies and reporting organizations with a narrower, less complex and less costly framework for making the appropriate determination of whether a set of assets and activities qualifies as a business.
The existing definition of a business under Generally Accepted Accounting Principles (GAAP), is “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.” According to the FASB, this definition is often applied too broadly, resulting in entities erroneously recording transactions as business acquisitions, when they are, in fact, asset acquisitions.
Under the new framework, a business must also include “an integrated set of inputs and processes that create or contribute to the creation of outputs.” Input elements may include intellectual property, employees and long-lived assets. Substantive processes refer to “systems, standards, protocols, conventions, or rules that when applied to inputs, create or has the ability to create or contribute to the creation of an output” that allows an entity to provide goods or services to customers or investment income or other revenue. In this definition, a business requires an input and substantive process but not an output.
Making the determination of whether a set of assets and activities qualifies as a business will require reporting entities to evaluate those inputs and processes through a practical “screen”. If substantially all the fair value of the gross assets acquired or disposed of is focused on a single, identifiable asset or a group of similar identifiable assets, the screen is not met. Therefore, the set is not considered a business and the transaction should be accounted for as an asset acquisition.
This new guidance has a significant impact on the acquisition of income-producing real estate, such as multi-family apartments or shopping centers. Under existing rules, entities frequently accounted for the acquisition of these income properties as a business combination, and the acquisition required them to analyze in-place leases at the acquisition date in order to place a value on this acquired future revenue stream. Subsequently, the entity would amortize the resulting in-place lease intangible over the life of the leases. In many instances, this analysis was time consuming and costly. ASU 2017-1 speaks specifically to in-place leases at the acquisition date and states that such items should be considered part of the value of the acquired asset, more specifically, the building acquired.
As a result of the FASB’s new, narrowed definition of a business, it is possible that an increasing number of entities will account for acquisitions as asset transactions, rather than business acquisitions.
Privately held business entities are required to apply the ASU to annual periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. Public companies must apply the ASU to annual periods beginning after have a December 15, 2017.
The professionals with Berkowitz Pollack Brant’s Audit and Attest Services practice work with businesses of all sizes and across all industry to assess and comply with a sea of evolving regulatory standards.
About the Author: Christopher Cichoski, CPA, is a senior manager with the Audit and Attest Services practice of Berkowitz Pollack Brant, where he provides business consulting services and conducts reviews, compilations and audits for clients in the real estate and construction sectors. He can be reached at the Miami CPA firm’s Ft. Lauderdale, Fla., office at (305) 379-7000 or via email at firstname.lastname@example.org.